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Tactical Asset Allocation, Part II

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Options Trader: Friday Outlook

There are those who believe high oil prices are the result of market forces--limited supply meets endless demand, which makes barrels of crude more expensive. In an October 2004 National Review article, “The Oil Bubble: Set to Burst?” it was argued that oil prices, at that time $62 a barrel, would soon collapse. In ten months, oil was $73 a barrel.1 All through oil’s five-year price surge, rising to $105 per barrel as of March 2008, there have been many voices asserting that the precipitous rise is all the result of speculation--unsupport... by the rudiments of supply and demand.2 Speculation will have an effect on oil prices if it leads to hoarding or an increase in private inventories of crude. Some espouse that inventories have remained at “normal” levels, which implies that the rise in oil prices is not the result of runaway speculation, but the consequence of decreasing supply and the rapid growth of developing economies like China and India.3 We would like to point out that the notion of high futures prices reducing physical supplies through “hoarding” has nothing to do with a “normal” level of inventories, but whether there exists a positive relationship between futures prices and oil stocks/inventories. For specifications including longer-term contracts that are inherently more speculative, the real price of oil appears to be determined predominantly by the futures price. Moreover, there is empirical evidence of hoarding in the crude oil market: both oil stocks/inventories and futures prices are found to be positively cointegrated/correlate... with each other.